Cash is King

After staying away from new acquisitions for the better part of 2007, Santa Monica, Calif. — based REIT Macerich Co. started the new year with a bang. On January 10, the firm announced it was buying the Shops at North Bridge, a 680,933-square-foot mixed-use property on Chicago's Magnificent Mile. To fund the $515 million transaction, the REIT partnered with the Alaska Permanent Fund Corp.

A few days earlier, on January 7, Jacksonville, Fla. — based REIT Regency Centers Corp. made its first acquisition play in six months. Partnering with the Oregon Public Employees Retirement Fund, Regency paid $76.6 million for a portfolio of seven grocery-anchored shopping centers located throughout the Southeast and the West totaling 482,651 square feet.

Other big deals that have closed since the beginning of November include a $540.8 million acquisition of a portfolio of office and retail properties in North Carolina by CBL & Associates Properties Inc. and the Teachers' Retirement System of the state of Illinois, a $214 million acquisition by Hull Storey Retail Group LLC of 11 properties in the Southeast and a $104 million acquisition by DLC Management of eight properties in the Southeast.

The deals are noteworthy because they signal that despite a steep dropoff in investment sales in the retail space — volume is down more than 50 percent over comparable periods from 12 months prior — buyers are still out there. At the same time, they mark a shift in the investing climate. Debt-laden private buyers — who had come to dominate real estate investment in recent years — have stepped away from the table. Today, cash-flush buyers have reclaimed the crown as the kings of the acquisition market.

“Buyers are still very active and looking to do deals,” says Joseph C. French, national director of retail properties with Irvine, Calif. — based brokerage firm Sperry Van Ness. “But they have to come up with a lot more cash, so it eliminates some [bidders] and makes them look at smaller projects.”

This appraisal should give comfort to prospective sellers, who in the fourth quarter of 2007 saw sales volume plummet. From September through December of last year, monthly sales volume in the retail sector amounted to little more than $2 billion, according to Real Capital Analytics, down from $7 billion in months prior to the onset of the credit crunch. In addition, the firm estimates that since July, buyers have backed out of deals worth more than $10 billion — and that's a conservative number, since the figure is based only on public reports.

To be sure, the dropoff is large in comparison with the past two years. But the projected volume still puts 2008 on pace to surpass the deal volume experienced in 2005, which at the time was considerd a banner year. That year, about $47 billion in transactions occurred.

Still, it seems clear that the market peaked last year. And this is the beginning of a correction. In addition to the drop in volume, sales prices have also fallen, just not to such a severe degree. Real Capital Analytics estimates that prices on deals completed in the past six months tended to be 5 percent to 8 percent lower than those achieved at the beginning of 2007. The Standard & Poor's/GRA Commercial Real Estate Index, meanwhile, shows that prices in the national retail sector moved down 1.55 points from June to September 2007, dropping the index from 161.80 to 160.25.

Cap rates are moving upward, as well: French notes that on class-B and class-C assets they have inched closer to 8 percent from the high of 6 percent in 2006 and 2007. New York — based real estate investment firm Stonemar Properties, for example, which focuses on dominant power centers in secondary markets, currently looks for cap rates in the high 7 percent and 8 percent range, up approximately 25 basis points compared to 2007.

Cap rates on class-A assets have held up better, but going forward, they will likely rise 25 basis points, says Robert Bach, chief economist with Santa Ana, Calif. — based Grubb & Ellis, while cap rates on class-B and -C assets will move 50 to 75 basis points from current levels. Overall, buyers should be looking for cap rates in the range between 7 percent and 8 percent, according to Net Gain Real Estate, a Mountain View, Calif. — based provider of commercial real estate investing information.

The change stems from the rankled credit markets. At the height of the recent real estate cycle, in 2006, buyers routinely borrowed 90 percent of acquisition costs and, in extreme cases, got financing worth 100 percent or more of their deal price. This was fueled a great deal by the then-booming commercial mortgage-backed securities (CMBS) sector. However, with just $9.9 billion in CMBS issuance in December (down from average monthly volume in the $30 billion to $40 billion range at its peak early last year), those loans are no longer readily available.

Traditional balance-sheet lenders — such as life insurance companies — have ratcheted up their origination volumes to fill the gap left by CMBS, but they're not overextending themselves. The price of debt has unquestionably risen.

As a result, the overall volume of loan originations for retail properties decreased 43 percent between the second and third quarters of 2007, the most recent reporting period, to 264 transactions, according to the Mortgage Bankers Association. Average loan size dropped by 14 percent, to $10.4 million.

That means buyers that relied on readily available debt to buy up new properties can no longer do so.

“What we have seen is that a lot of the players that have been active over the last four years are out of the market,” says Jonathan Gould, CEO of Stonemar. “The firms that are left are those that focus on real estate fundamentals and are not buying properties just because they can.”

The bid-ask gap

Another factor at play, brokers say, is that sellers have not fully adjusted to the new market conditions. Many are still operating under a 2007 mindset, while buyers are making 2008 offers. That's created the largest “bid-ask” gap investment pros have seen in recent years. And until sellers fully adjust expectations to the realities of the new market, deal volume won't fully recover to past levels. In the meantime, the gap between buyer and seller expectations is leading to longer negotiating periods, as well as to properties being pulled from the market when sellers don't get the bids they're expecting.

“Right now, what you are seeing is a pause; there is definitely repricing going on,” says Susan M. Smith, editor in chief of the Korpacz Real Estate Investor Survey, published by PricewaterhouseCoopers. “Whenever you see buyers and sellers not agreeing on prices, it will stall the market.”

An indication of new buyers' hesitancy can be seen in the Fall 2007 report from the Chicago-based Real Estate Research Corp. Investors, which now gives neighborhood shopping centers a rating of 5.1 on an investment conditions scale of 1 to 10, down from 6.2 in the third quarter of 2006. Power centers get a rating of 4.9, down from 5.5 in 2006, and regional malls a rating of 4.6, down from 5.3 and the lowest rating overall in the commercial real estate sector.

The bid-ask gap will soon play itself out and that will ease some of the impasses at bargaining tables, according to Stephannie Mower, executive vice president and managing director of investment services with Houston-based real estate services firm PM Realty Group. And that's because she expects to see a renewed wave of interest from institutions that had been priced out of the market in years past.

For example, many REITs, which are typically punished by analysts and investors for carrying high debt loads, sit today with clear balance sheets and, in some cases, barrels of cash. Pension funds and foreign players also probably won't be constrained by the problems in the debt markets. The fact that these players may be willing to become more active is borne out by the spate of recent joint venture deals announced by Macerich, Regency and CBL, which were completed with pension fund partners.

Another example is Farmington Hills, Mich. — based Ramco-Gershenson Properties Trust, which in January purchased two centers in the Midwest with a combined 418,000 square feet for $69 million in partnership with an investor advised by Heitman LLC.

With more than $364 billion in funds, according to Torto Wheaton Research, a Boston-based independent research firm owned by brokerage house CB Richard Ellis, pension funds, REITs and foreign investors still have plenty of money to burn.

“I think you will see all-cash buyers come back to really rule the market,” says PM Group's Mower.

Sellers have spotted the trend as well. For example, Barry Argalas, senior vice president of acquisitions and dispositions with Regency Centers, says some sellers — realizing how tough the market for acquisitions has become — have come knocking at Regency's door, pitching potential deals.

“Our phones are ringing more often given that some property owners are reluctant to enter into a public marketing campaign and not transact,” he says. “The time lost on a marketing effort and failed transaction could negatively impact the value of their center”

The firm typically limits its leverage levels to between 50 percent and 60 percent and found itself priced out of bidding auctions in recent years even for attractive properties it would have loved to add to its portfolio. Now the company is looking at a climate where it will have the pick of the litter.

No more big deals

Still, even if REITs and other institutions do ratchet up acquisition volumes, you won't see the kind of large portfolio deals and mergers that made headlines the past two years, according to French (think Centro Properties Group's $6.2 billion acquisition of New Plan or Developers Diversified Realty Trust's $6.2 billion acquisition of the 44-million-square-foot Inland Retail Real Estate Trust portfolio, both of which were announced in February 2007). In those deals, buyers were often so eager to get their hands on prime assets, they agreed to take on less-than-stellar properties as well, just to close the transaction. But with NOI growth gaining in importance (cap rate contribution to return in the retail sector went down from 10.27 percent in 2005 to 7.69 percent in 2007, according to Torto Wheaton), they are no longer willing to take the bad with the good.

“In that respect, the market has really flipped — whereas there was a portfolio premium when the cycle was at its peak, today it is just the opposite,” says Argalas, who notes that Regency will be disposing of its properties on a one-off basis in 2008. “Less buyers will be interested and you will have to offer a discount.”

Core values

Even so, the market should still see a healthy amount of sales activity in 2008. Regency Centers, for example, plans to spend $300 million on acquisitions this year — in line with its previously set acquisition targets. And Stonemar Properties will increase its spending up to $150 million, from $70 million in deals completed last year.

The main difference will be that most buyers will concentrate on the healthiest, best-positioned centers.

“People will look at more than just the cap rate; they will ask what the upside is on the property, what retailers can go there, what is the build-out going to cost and what the return is going to be,” says Mower.

Even top-tier assets will come under scrutiny. In addition to prime location and dominance in a given trade area, buyers will now look for a diverse tenant mix to insure themselves against possible closings.

“They will not want to have 20 Home Depots in their portfolio, whereas a year ago they would buy every Home Depot — anchored center they could,” says French. “It's about balance now.”

Overall, brokers and analysts expect that the lull that's gripped investment markets will hold a bit longer before things loosen in the second half of the year.

“Sales activity will pick up in 2008 as the year progresses, but I think volume will be down significantly from last year,” says Bach. “There is still a lot of risk aversion [in the market] and for that reason, there will be a flight to quality, as the newest, best-located centers are the ones still getting sold. For retail, sales will be down at least 25 percent compared to 2007.”